Can Renewed 'Animal Spirits' And The Fed's Money Keep This Bull Alive?

As the bulls gloat over this anemic rally - driven higher by the algos and the Fed's surrogates -- in a severely volume deficient ascent to new highs I found myself dozing off a few times yesterday. I usually look forward to my work but the most exciting thing going on yesterday was my $5.00 wager on whether "they" - whoever "they" are - would once again push the Dow into positive territory at the close. A total gain of just 8 points in 2 days leads me to the conclusion that the "Bernanke put" has anesthetized the whole market.

"They" did push the market into positive territory though and I won the bet. It was small consolation as my bear etf's -- (NYSEARCA:FAZ), (NYSEARCA:TZA), (NYSEARCA:TECS) and (NYSEARCA:UVXY) -- lost a whole lot more than $5. At least you've got to give me credit for having the courage of my convictions. More importantly I have a commitment to the bear side of the market and that won't change until there is a reason -- other than short-term price movements - for me to abandon the position. I know that I can't pick the top of this market but I also know that those who are quick to disparage those who choose to fade this rally won't do any better than I will at picking the top.

John Hussman made the following remarks on February 3, 2013:

Present market conditions now match 6 other instances in history: August 1929 (followed by the 85% market decline of the Great Depression), November 1972 (followed by a market plunge in excess of 50%), August 1987 (followed by a market crash in excess of 30%), March 2000 (followed by a market plunge in excess of 50%), May 2007 (followed by a market plunge in excess of 50%), and January 2011 (followed by a market decline limited to just under 20% as a result of central bank intervention). These conditions represent a syndrome of overvalued, overbought, overbullish, rising yield conditions that has emerged near the most significant market peaks - and preceded the most severe market declines - in history. . .

I agree with Hussman. I don't know when we capitulate but I think we will. Hussman closed his Weekly Market Comment this way:

I'll end with a review of how we can expect market psychology to evolve over the completion of the present market cycle. It's the same sequence that I suggested in April 2000:

"This is my retirement money. I can't afford to be out of the market anymore!"

"I don't care about the price, just Get Me In!!"

"It's a healthy correction"

"See, it's already coming back, better buy more before the new highs"

"Alright, a retest. Add to the position - buy the dip"

"What a great move! Am I a genius or what?"

"Uh oh, another selloff. Well, we're probably close to a bottom"

"New low? What's going on?!!"

"Alright, it's too late to sell here, I'll get out on the next rally"

"Hey!! It's coming back. Glad that's over!"

"Another new low. But how much lower can it go?"

"No, really, how much lower can it go?"

"Good Grief! How much lower can it go?!?"

"There's no way I'll ever make this back!"

"This is my retirement money. I can't afford to be in the market anymore!"

"I don't care about the price, just Get Me Out!!"

Hussman makes the point I want to make and that point is this - the fundamentals do count and no matter how you choose to view them or what spin you put on them they are what they are and they do make a difference. No attempt to corner a market that I am aware of has ever succeeded and that is what the Fed is doing - attempting to corner the market.

Lest anyone think that isn't true or that the Fed is not back stopping market sell-offs I suggest you look at the following charts. The first chart compares the weekly closing price of the DJIA (NYSEARCA:DIA) with the Fed's balance sheet since the first of the year. I let Excel draw a regression line and calculate the R-square value. R-square in this case is an astonishingly high .953.

Just to emphasize that the Fed's surrogates are keeping a floor under the Dow stocks and in so doing, preventing a broad market sell-off in other stocks, I decided to see how closely correlated the Dow is to the S&P 500 (NYSEARCA:SPY). I knew the S&P would correlate closely to the Dow but suspected the Dow might not be as highly correlated to the S&P as it was to the Fed's balance sheet. I was right - the R-squared value calculated by Excel was .8967.

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You can accuse me of being a conspiracy theorist if you want but the numbers do offer support for my thesis that the Fed is not only propping stocks through the psychological impact its actions have on investors - it is printing money that is finding its way directly into the stock market through some sort of contrived arrangement with whoever is carrying out their agenda.

I made this assertion several weeks ago in different articles and since then I have witnessed the exact situation I described occur day after day. Any weakness in the market is halted by aggressive buying of the Dow stocks, which works to pull the broader market higher in sympathy. It is happening every day of late and it is becoming blatantly obvious that this is occurring.

As far as I can tell there are four broad groups in the market today -- the bulls, the bears, the algos and the Fed's surrogates. The bulls and the bears are in - probably all in - and just waiting. The Fed's surrogates remain on the sidelines until they are needed. They are only needed if the market sells off a quarter of a percent or so. The algos are programmed to buy and sell in synch with the euro and yen's movement, which has been pretty minimal since the first of the month. Of course at the end of the day the Fed's surrogates step in and buy the DOW with sufficient volume to push it into positive territory at the close. Maintaining a corner on the market is after all, dependent on a higher close no matter how small.

John Coates, a former hedge fund trader turned neuroscientist, wrote an excellent book - "The Hour Between Dog And Wolf" - on the physical transformation that takes place just prior to a fall. The title refers to that moment. Coates describes traders in this mind state:

They become cocky and irrationally risk seeking when on a winning streak.

There are many in the markets today who demonstrate the characteristic Coates mentions. He explains that there is a real and physiological change that occurs when traders are making money and the bulls in this market have been making money. I think I heard today that we haven't had this many consecutive up days for 26 years.

In defense of the bears

I have no problem with those who choose to ride the Bernanke bull as long as they can. I don't even have a problem with those who really believe the economy is finally gaining traction and the market is going to explode from these levels based on an improving unemployment situation, improving housing market and the "animal spirits" they see emerging in the consumer in recent weeks.

The facts are that we have gained a lot of jobs in recent years and we are seeing a little more activity in the housing market. Whether the consumers' "animal spirits" are finally surfacing is a little less clear but recent positive spending patterns and the drop in savings suggests that this too may be occurring.

A reader asked me some time back what would change my mind about my prediction that we would enter a recession in the 1st half of 2013. My answer was that if consumers and businesses began to borrow and spend then the massive liquidity that the Fed has injected into the system could fuel an explosion in M2 and higher rates of inflation that would produce a real recovery. It is basic Keynesian theory and if that is what occurs I will be wrong on my recession call.

What bothers me though is the spin being put on this data. For example, I wrote an article this week that explains the process that the BLS uses to calculate unemployment. I noted that if the BLS had left the "labor participation rate" at 63.6 as it was in January we would have had 7.9% unemployment as we did in January. I also noted that those newly employed workers would probably not add to GDP as many of them were probably drawing extended unemployment benefits before they got a new job and therefore they were spending even though they were unemployed and that new paycheck wouldn't add to GDP.

Consider that there is still a lot of negative data but we just don't want to focus on these negatives. Here is an excerpt from the U.S. Department of Commerce on January, 2013 durable goods:

New orders for manufactured durable goods in January decreased $11.8 billion or 5.2 percent to $217.0 billion, the U.S. Census Bureau announced today. This decrease, down following four consecutive monthly increases, followed a 3.7 percent December increase. Excluding transportation, new orders increased 1.9 percent. Excluding defense, new orders decreased 0.4 percent.

Real disposable income decreased 4.0 percent in January, in contrast to an increase of 2.7 percent in December. Real PCE increased 0.1 percent, the same increase as in December.

Or how about looking at the GDP chart, which printed negative (now revised to + .1%) in the 4th quarter.

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Let's take a look at all the components of GDP as well just to get a clear perspective of the problems we are faced with.

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The only component left is Personal Consumption Expenditures and it did print in the positive in the 4th quarter of 2012. The other three components of GDP printed negative and two of those three printed really negative. Government Consumption/Spending is back to recession lows. Although the Export-Import component isn't as low as it reached in 2009 it is certainly in recession territory.

We will see how these numbers come in for the first quarter of 2013 but keep in mind we have a situation in the eurozone that is getting worse and China is slowing down as well. Consider that we don't live in a bubble today. It is a global economy and the US is suffering a contagion effect from the global slowdown.

As to Government Consumption/Investment it is not likely this GDP component will get better in the coming months. We do know that the "sequester cuts" are here to stay. We also know that the forecast is for a loss of 750,000 jobs in 2013 from the "sequester." Assuming all other components remain equal - a job loss of 750,000 will push unemployment back up to 8.2%.

The only good number out of the four GDP categories is Personal Consumption Expenditures. Here is the chart:

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Personal income and expenditures are a huge deal and matter a lot. The post recession recovery has been plagued by cash hoarding - both in the business community and the private sector. Fear and anxiety create this phenomenon. Who knows whether or not they will be the next one to receive their walking papers and so prudence is the natural course to take.

As that fear and anxiety subsides the consumers' "animal spirits" are ignited and that can be a major driver in GDP growth and therefore top line sales and profits. The chart above suggest this may be the case and if it is there is certainly justification for stocks at current levels as personal consumption represents roughly 70% of GDP.

On the other hand there is a significant divergence between stocks and GDP as the following chart shows. Even though there is not a significant correlation between GDP and stocks in the short term GDP does matter and the chart below indicates an unusual divergence. Clearly one of these two trends will not continue.

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The question we need an answer to is whether stocks follow GDP or GDP follows stocks. The next chart might give us a hint. It compares personal expenditures to personal income. Take a look at the chart as it may be the most important chart presented here:

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What is odd about this chart is the very significant jump in personal income in the 3rd and 4th quarter of 2012. My own interpretation of this anomaly - if it is an anomaly - is that the tax debate in the last quarter of 2012 along with very high cash reserves caused a number of companies to accelerate dividend payouts in 2012. If that is the reason for the big spike then it is a one time anomaly and not a trend. That interpretation is supported by the drop in personal income in January of this year.

If this is a one-time anomaly then it is hard to conclude that revived "animal spirits" will be the driver of further increases in personal consumption in the coming months. The reason is that the income won't be there going forward to support further increases in personal consumption. The only other time during the period reflected by the chart above that personal income spiked like that was in 2008 and the subsequent drop in the next month was even more dramatic than the spike higher the previous month.

Concluding thoughts

I have been bearish on the markets for about six months now. Some of my trades have worked out and others haven't fared so well. I was bearish Gold (NYSEARCA:GLD), Apple (NASDAQ:AAPL) and the banks (NYSEARCA:XLF). I was bullish the dollar (NYSEARCA:UUPT). Clearly the banks haven't fared very well nor has my broader market bear call as most of the major indices are putting in new highs.

I will remind readers that I did concede the possibility that stocks could move higher back in January (here):

The truth is I can see a capitulation sell off occurring at any time. We are already up 6.2% on the S&P on the year and 12.7% from the November, 2012 lows. In part 1 of this series I made mention of the risk/reward in holding stocks for the all time highs. My best case scenario for 2013 is a range basis the S&P of 1600 on the high side and 1260 - the 2012 lows - as the low side.

I don't assign a high probability to either of these levels defining the 2013 range but again a best case scenario that offers 100 points in gains versus 200 points in risk is just not a good trade. Tops are extremely difficult to call and I have no crystal ball that tells me where we peak or when. A crystal ball isn't necessary to forecast a probable trading range for 2013 though. The divergence between stocks and the economic metrics we use to assess economic health leave little in the way of optimism for 2013. I will list those metrics for your consideration but first I want to repeat one more time a statement that I made regarding the nature of stock markets:

"The fact is we want the markets to move higher, we expect the markets to move higher, we invest on the basis that the markets will move higher and we bias our reporting of economic data toward the buy side. In other words we emphasize the good data and discount the bad data. We frame our perceptions around what we want to happen and build arguments that will support those perceptions necessarily discounting the negative."

There are a number of very competent analysts calling for a recession in 2013. Right now that possibility seems very remote and there are a number of traders/investors that are literally laughing at these forecasts as stocks trudge higher day after day. Maybe they will have the last laugh or maybe not - we just don't know at this point.

I have no way to know where we put in a top and my guess is that few will identify it as a top when it occurs. So many long-term buy and hold traders make the point that short-term price prediction is not possible and then deride those who have a longer-term bearish perspective. I would suggest that the knife cuts both ways here. For those forecasting a recession in 2013 and a sharp sell-off at some point in 2013 the jury is still out and will remain out as to how accurate these calls are until December of 2013.

No short-term rally negates the accuracy of the longer-term market call. Risk/reward matters and so does price. Few will be able to call the top in this market and that includes the bulls and the bears. Anyone choosing to disparage those who are looking at the fundamentals and making a call for lower stock prices in 2013 need to keep in mind 2013 is just under way and there is just no way to assess the accuracy of those calls at this point.

Disclosure: I am long TZA, FAZ, TECS, UVXY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The data used to construct the charts in this article came from EconStats: www.econstats.com/

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